Looking at Liquidity Services
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By rackled
June 29, 2007

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I could not wait to post this, although it is incomplete, because this distillation of LQDT's business model has re-invigorated my interest and excitement in this company and I hope people will too become excited about it as quickly as possible. I will post additional information in the near future, because I need to go to the city and kill a few brain cells.

Liquidity Services Inc. (LQDT)

Liquidity Services is involved in the field of reverse supply chain management. As explained by the company, this means that LQDT helps governmental and corporate entities sell their surplus and salvage assets, with the first being excess items that corporations were unable to sell, and the second being things such as scrap metal, used vehicles, and steel, that can be salvaged from old and used assets. From the 10-K: "These assets generally consist of retail customer returns, overstock products and end-of-life goods from both the corporate and government sectors." In reality, I think LQDT facilitates the sale of anything that these entities want to get rid of, which are not of premium value to the company or government, but nonetheless have some value to some buyer. The market will always exist for several reasons: (1) Supply chain inefficiencies, such as inaccurate market forecasting. (2) Product innovation, which makes products obsolete, which is especially significant in the new economy. (3) Return policies of retailers. (4) Government regulation which demands recycling of surplus material.

LQDT provides this liquidity by creating a marketplace for these assets via several online sites. As the name implies, these sites provide liquidity in the market for surplus and salvage goods. Liquidity also provides additional services beyond their online marketplace which generate additional revenue and which serve their customers. They help their customers from sale to distribution by doing such things as performing sales and marketing, providing for warehousing and transportation, and ensuring transaction settlement by checking the credentials of buyers and sellers. In short, they provide an end to end service that takes the headache out of this process.

LQDT contends that the market suffers from a lack of liquidity generally. In other words, it is inefficient, which prevents buyers and sellers from getting what they want for the prices they want, and perhaps most importantly, prevents them from being able to derive a fair value for their assets, which makes buyers and sellers less confident in their transactions. The reason the market lacks liquidity, the company contends, is that the market is highly fragmented and disjointed. The lack of a single market forces these entities to try to buy and sell these assets through back channels and occasional relationships and through the occasional reverse supply chain facilitator, which is almost always small time and regional. The entities also have not invested significantly in reverse supply chain management themselves and really have no desire to, since it outside their core competency and they would rather focus on their business. Therefore, LQDT functions, in effect, as an efficient outsource that negates the need for this investment. This is one of the reasons that LQDT is able to charge the premium that it does. It is really the only and best game in town. By providing a large and liquid market, LQDT believes that it fills a huge void.

This market, LQDT contends, is poised for enormous growth of which LQDT can capture a huge chunk. "According to D.F. Blumberg Associates, Inc., a research and consulting firm, the estimated reverse logistics market in North America will grow from approximately $38.5 billion in 2004 to over $63.1 billion in 2008." This is evidenced by the growth in LQDT's own business. "During fiscal year 2006, the number of registered buyers grew from approximately 386,000 to approximately 524,000, or 35.7%... Our revenue has grown at a compound annual growth rate of approximately 35% since fiscal year 2002."

At this point, you may be dismissing LQDT as typical dot com with a questionable moat that will inevitable face significant and threatening competition. The company contends, however, and I believe that this is a complete misconception and there is a very significant moat that is durable and even likely to strengthen over time. Warren Buffet says that he only wants to invest in companies that strengthen their moat over time, and that even sacrifice short-term performance in order to pursue this goal. If LQDT continues to deliver on its astounding growth, I believe this is precisely that sort of company.

(1) LQDT is a first-mover and enjoys all the attendant benefits. I don't know of any company that is currently in the same space as LQDT. As the first mover, LQDT benefits from being the first to establish a presence and brand for its customers and this brand serves as a moat against new competitors.

(2) LQDT benefits from the E-Bay, or networking effect. This is much touted and hyped, but it is apt in this instance. As LQDT accretes customers, there is a strong incentive for any new entrants into the market to use LQDT because it offers the largest marketplace to buy and sell. "During the fiscal year ended September 30, 2006 we had approximately 993,000 auction participants in our online auctions from our registered buyers. During fiscal year 2006, we grew our registered buyer base by 35.7% or approximately 138,000. LQDT serves not just the US market, but also European entities. As buyers continue to discover and use our online trading platform as an effective method to source assets, we believe our marketplaces become an increasingly attractive sales channel for corporations and government agencies. We believe this self-reinforcing cycle results in greater transaction volume and enhances the value of our marketplaces." Speaking to this, in the most recent quarters, LQDT has increased corporate gross volume by an amazing 161% YOY and 46% sequentially. At some point, LQDT will reach a critical mass where this incentive is so strong that LQDT will become the default reverse supply chain facilitator. This moat will serve as strong disincentive to new entrants, who know that it will take a lot of resources to establish themselves as a legitimate competing network, and they are taking the substantial risk that they will fail and never be able to do so.

(3) LQDT is much more than just a website. I think this is one of its greatest moats. It provides marketing, payment collection, dispute resolution, logistics/distribution services, and credentialing, which is extremely important to professional customers who are conducting large transactions across the globe and demand secure transactions. In particular, LQDT verifies for its government clients that buyers have the necessary security access and export controls for at-risk products, something which LQDT itself needed to be credentialed for. LQDT also provides warehousing for goods that are sometimes enormous in size, such as tractors... and jets. This decreases margins, but it also creates a very large moat, because this service is not only unique, but any would be competitor would need to first build warehouses and acquire property to provide the same service, which is capital intensive. LQDT has made and plans to continue making substantial investments in this area, with its recent acquisition of a regional player being a primary example. LQDT contends that it has made most of this investment up-front and has yet to see the benefits reflect in earnings as revenue falls to the bottom line and capital expenditures are no longer required.

(4) Liquidity is not just an online marketplace disconnected from its customers. It has formed and seeks to form special relationships with its business and governmental clients. It has said that it has already formed several special relationships with some Fortune 500 companies. This makes logical sense, as stated previously, because LQDT provides very specific services to its clients. Its special relationship with the US government, in particular, is undeniable, and it also has relationships with several European governments. It serves the UK Ministry of Defense and the US Department of Defense in the US, the United Kingdom, Germany, and now, as recently announced, Puerto Rico and Guam. LQDT is the exclusive - yes, exclusive - contractor for the US Defense Reutilization and Marketing Service for the sale of surplus and scrap material for the US DOD. "We provide services in over 1 million square feet of military warehouse space at over 150 military bases throughout the United States." Talk about a moat. The two contracts they were awarded relate to "computers, electronics, office supplies, equipment, aircraft parts, clothing and textiles" and "metals, alloys, and building materials." Speaking to the strength of this relationship are the substantial portions of profits that LQDT is entitled to, which were recently increased from 20% to 23% and they are potentially entitled to up to 30%. "DoD also reimburses us for actual costs incurred for packing, loading and shipping property under the contracts that we are obligated to pick up from non-DoD locations." This does not happen unless the customer is satisfied and wants more interaction with LQDT. Accounting for approximately 50% of LQDT's revenues, the departure of the DOD would be a substantial blow to LQDT, but the above attests to the strength of the relationship.

(5) All entities, but small businesses in particular, benefit from LQDT because they have neither the resources nor the connections to pursue reverse supply chain management themselves. LQDT offers a low cost and easy point and click interface from which they can pick and choose as they see fit.

Speaking briefly to valuation, LQDT is what I would classify as an extreme growth stock. With a trailing PE of 57, a forward PE of 31, and an EV/EBITDA of 27, LQDT is hardly cheap, but this is the price of extreme growth. LQDT is following through on its promise of having a network effect for corporate America, and as stated previously, if it continues to follow through, I believe this company will continue to grow into an extremely large company, perhaps for decades to come. Imagine if LQDT became the network for global reverse supply chain management, for global corporations and governments alike. It has an EV value of only 465 million, so it is still very small. It has a substantial amount of cash, so its fundamentals are strong. Its earnings are positive and it produces cash flow, so its profitability is real and not imagined or in the future. It produced 4,787 in net income in the first six months of 2007, as opposed to 3,396 in 2006, substantial growth. Just today it revised its earnings estimates up for the full year to ~ .43 cents.

Its lowest PE over the last two years has only been 50 so at its current PE, it is pretty much near its bottom. Its high PE is about 65. As I said earlier, however, the company has made substantial upfront investments in infrastructure which it has not benefited from as of yet, and these expenditures currently mask the true EPS of the company. I believe that LQDT is thus reasonably cheap on a historical basis. The lowest PPS I have seen it go is approximately 17.50. Stan and I both thought 15 would be a good entry price, but it never got there. I don't think it is likely to get there unless the market sells off. At this point, I would suggest a rather small entry and accumulation on weakness not related to the company, but to the market in general. If the company grows as expected, this small investment will grow to be substantial, and the owner can hold for a long time without really worrying about the company, counting on its long-term business prospects to see it through.

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